Glassman: Some investors get lucky, and others are just genuises

WASHINGTON -- Among financial scholars, it's an article of faith that the vast majority of investors can't beat the stock market regularly.

According to the traditional academic literature, if you invest long enough, spread your money around in a diversified portfolio and hang on through thick and thin, then you are nearly certain to end up doing about the same as the averages -- an annual return, before taxes and expenses, of about 10 percent.

Consider mutual funds, which are run by highly paid experts backed by large research staffs. Such funds have a huge incentive to beat the market since standout funds pull more cash from investors and thus more fee income for managers. Yet academic studies show that, on average, mutual funds actually do a little worse than the market as a whole.

As a result, the smartest strategy would seem to be owning low-cost index funds, like Vanguard Index 500 (VFINX), which mimic nearly the entire market.

Yes, a few investors do beat the market. Some get lucky. Others get higher rewards because they take higher risks. And a tiny minority of investors may simply be geniuses -- like Warren Buffett, who calculates in the latest annual report that his company, Berkshire Hathaway (BRK), has increased its book value at an average rate of 22 percent a year since 1965.

The reason that most investors neither consistently beat the market nor consistently underperform it, is explained by what economists call the "efficient market hypothesis," developed by Eugene Fama of the University of Chicago nearly 40 years ago. The idea is that the price of a stock today reflects all the public information that can be known about a company, the market and the economic environment. In other words, today's market price is the "right" price, and tomorrow's price (because it is based on unknowable information) cannot be predicted today. From today's perspective, future prices move in a "random walk."

The researchers found a significant minority of investors can beat the market, not through luck but with what appear to be superior stock-picking skills.

Coval and his colleagues started with the records of 110,000 accounts at an undisclosed discount brokerage firm. They zeroed in on 16,668 diversified accounts whose owners had placed at least 25 trades in the sample period, between January 1990 and November 1996. They found that the top 10 percent of investors "earn excess returns of 15 basis points a day." That's a huge number. These talented investors beat the indexes by 3 percentage points a month!

"This evidence," Coval and his associates write, "does not support the efficient market hypothesis. The ability of individual traders to select out-

performing companies is not confined to small firms or only a few firms in which the traders transact frequently," so it is not simply the result of taking more risks or "trading on inside information."

While the paper has not been subjected to the rigors of peer review and while it covers a fairly short time span, it does suggest some important lessons for small investors:

· You can beat the market. "Our results suggest that skillful individual investors (can) exploit market inefficiencies to earn abnormal profits," write Coval, et. al. In other words, some people -- maybe as many as one-fifth of investors who take the stock market seriously -- can really find undervalued companies. So the stock-picking game is not a futile exercise.

· Still, it is unlikely that you are among the favored few. How can you tell if you are? According to the researchers, you should examine your portfolio over time and see if you have beaten the market with, say, two-thirds or more of your stock picks. That may be an indication you have the gift. Conversely, if you keep selecting losers, switch to index funds.

· Individuals seem more likely to beat the market than mutual funds. Why? First, individuals trade much smaller positions, so their purchases and sales don't affect prices as much. Second, the scholars write, individuals "are less constrained than mutual funds to hold a diversified portfolio or to track the market or a given benchmark." Also, they don't have to register great figures every quarter or lose their jobs.

Still, some experts do beat the averages over long periods -- although they usually do it through risky strategies, like concentrating their portfolios in only a few stocks. Over the past 10 years, for instance, one of the best performing mutual funds has been Sequoia (SEQUX), managed by William Ruane and Robert Goldfarb. Sequoia has returned an annual average of 14.2 percent, compared with 7.2 percent for the average fund and 8.6 percent for the benchmark Standard & Poor's 500 stock index.

But Sequoia's portfolio is highly focused. It owns only 15 stocks, and the top five represent two-thirds of total assets.

Ruane subscribes to Buffett's philosophy on diversification: forget it. Buffett likes to quote Mae West, who said, "Too much of a good thing can be wonderful." There aren't that many great stocks in the world, so buy lots of the few you find. Sequoia owns huge chunks of Berkshire itself; Fifth Third Bancorp (FITB); Progressive Corp. (PGR) insurance; TJX Cos. (TJX) discount retailer; and Fastenal (FAST), seller of screws, nuts and bolts; and not much else.

My suggestion is to watch smart managers for stock-picking clues but to play it safe with more diversified portfolios. Don't own 15 individual stocks; own 30. Or better, own an index fund and a few managed funds along with 15 individual stocks.

Buffett viewed the Efficient Market Hypothesizers with profound skepticism: "Observing that the market was frequently efficient," he wrote in 1988, "they went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day."

Yet, for most small investors, beating the market is practically impossible, and it is dangerous to take foolish chances trying.

The good news is that you don't have to. If the future looks anything like the past, you should be able to double your money in the stock market every seven to eight years by owning index funds or low-cost diversified managed funds. No guarantees, of course. The market isn't that efficient.

Of the stocks mentioned in this article, James K. Glassman owns Berkshire Hathaway. His e-mail address is jglassman@aei.org.